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Subject: Valuation of RBs and RMs

Tom,

Thanks for your reply to my Message No. 78. I agree with you completely, that once you have bought shares in a really great company, a person shouldn't worry about the price, since the performance of the company is much more important. I agree that an investor should hold such companies as long as they are maintaining their market position and hopefully you can hold them forever. I believe that this is why Warren Buffet hangs on to Coca Cola and Gillette. He can never really lose on these investments since the share price is now so much higher than his purchase price.

The difficulty for me, and I suspect many others, occurs when you do not yet own shares of one of these great companies. You have to determine a price at which you are ready to jump in. You want to buy the shares at a price which you believe will bring you a reasonable return on your investment. For example, if you had bought Iomega at it's peak price, you would have lost a lot of money, even if the company was and still is a great company. Even if you now keep the company for the rest of your life, it will be a long time before you get back the money you lost on the initial purchase.

I believe, therefore, that when you don't already own shares in a great company, or if you want to add to your position, the market price for the shares becomes very important. If you agree with this, then it follows that we must have a method to determine what a reasonable share price might be, for both Rule Breakers and Rule Makers.

As a suggestion, it might be useful to break the share price into a “tangible” component and an “intangible” component. (You may wish to introduce other terms, its just that engineers have a fairly limited vocabulary). The tangible component is that portion of the current market price which we can justify based on known information. For example, in the case of Rule Makers, we can estimate the tangible share price based on this years earnings, the historic earnings growth rate and the historic price to earnings ratio. In the case of Rule Breakers, we might estimate the tangible component of the share price by estimating the size of the market, potential revenues and estimated net earnings. My opinion is that even if these estimates are fairly crude, they can give investors a framework in which to monitor the performance of a particular company. For example, there has been some useful discussion on what At Home's maximum and minimum revenues and profits might be expected to be several years from now, which helps to determine whether the current market price is reasonable.

The intangible component of the share price is that portion of the current market price which exceeds the tangible share price. In my view the intangible component represents the speculative portion of the share price. If there is some bad news, either about the economy or about the particular company, then it is the speculative portion of the share price which can justifiably drop to zero. If the price drops lower than the tangible share price, then I would happily jump in and buy lots of shares. (Assuming that the company's overall performance had not changed).

The bottom line of all this is that if we want to buy shares in a great company, or we want to add to our position in a great company, we should wait until the market price approaches our estimate of the tangible price. Having said all of this, you should know that to my great chagrin, I have been waiting for several years for the market price of CSCO and MSFT to fall to within striking distance of what I believe is their tangible share price, and they never seem to come close. So maybe we need to have a third component of the share price called the tangible portion of the intangible component of the share price ….just kidding :>)

I look forward to any comments you or anyone else may have on these ideas.

Fool's Forever!

Bruce Smith

PS: Paco – No kidding – did you really smoke crack with Kathy Lee Gifford? I'm impressed!
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Paco – No kidding – did you really smoke crack with Kathy Lee Gifford? I'm impressed!

Well, she was smoking crack. I was just watching and playing with her hair. Eventually I had to snatch that glass nipple away from her. You know, it gets old after a while. She offered to do some stuff if I gave it back, but that made me feel uncomfortable. Would that really be fair to Frank? It was a morality thing for me.


Paco
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I thank you for the excellent note, even though I disagree with the fundamental premise of the approach (and, of course, I may be dead wrong in disagreeing).

I do not believe that your impression of a company should change, based upon whether you do or do not own shares in it. The marketplace doesn't care whether or not I own shares in a given company. So why should my approach to owning companies change based on whether or not I already have a position.

When Buffett holds Coca-Cola until he passes into the next world, he is essentially reaffirming his buy decision every market day of the year. Likely he doesn't follow the business on a daily basis, but one quarter after another, his decision to hold is quite a bit like a buy decision.

And I should say I believe this is more about future ownership than future taxes. Certainly, capital gains taxes come into play. But I don't think they profoundly affect Buffett's decision to hold Coke at $88 all the way down to $60 and back up. In other words, I question whether the Berkshire gang is really performing weekly stock valuations of its holdings to determine whether or not to buy, sell, or hold.

This doesn't mean that they do not use some valuation methodology. But I suspect that as Mr. Buffett has ascended the throne of the financial world, he has increasingly focused on the quality of the people involved in a business and the force of their business model and less about the present price of their stock stubs.

Regardless of Buffett, I would just suggest that for those using the public markets as a long-term vehicle for business ownership, price timing is tens or hundreds of times less important than finding the superior and sustainable business models available. I could cite your experiences with Microsoft and Cisco as examples to support this, but why not share my own? I sold Microsoft in 1990. I sold Cisco in 1994. And I sold Dell in 1994. I also invested less into America Online in 1994 because I was concerned about the price of their stock.

I think that frustration is not unique to me and those three companies. It has been happening to potential investors in General Electric, Pfizer, Coca-Cola, Merck, AT&T, Johnson & Johnson, Schering Plough over the past fifty years. The same thing has been haunting potential investors of Microsoft, The Gap, Intel, Cisco, America Online, Home Depot, Wal-Mart, and the stocks listed above over the past fifteen years.

I wonder how important it was to know precisely when to buy The Gap during this 22-year period that it has compounded 26% annual growth. I wonder when a potential investor in Merck over the past forty years was best off trying to pick entry points (risking missing out altogether) rather than just buying into what has been 18% annual growth over those last four decades.

So much of this is how we choose to look at the markets and what we choose to look for. The shorter-term term the investor's horizon, the more valuation should drive her actions. The longer-term the horizon, the more than quality people and superior models should be the drivers. In this portfolio and in most of my work, I've chosen to extend the time horizon with every passing day -- making valuation less and less important.

If, by buying Cisco, I am paying 30% more than the company is worth today, it's likely I won't remember that if Cisco then compounds 20% annual growth over the next twenty years. I will have made 27x my money over that period. If I can do that without commission costs, with long delayed tax costs, and without adding any new money, I would hope that I would find this sufficient to support a rather high quality of life. Particularly if I added new money along the way -- and maybe even a few Rule Breaking stocks.

Given this, the challenge I meet as an investor is the challenge to find the best ten companies in the world. I won't nail all of them. But even just a handful will generate substantial wealth over twenty years. . a wealth that is far greater than mutual funds and the vast majority of active money managers are providing individuals with today (with fees and taxes factored in).

I will close this overlong note with a note that just came under my door at a hotel in Denver. The staff drops a note with a THOUGHT FOR TOMORROW under your door here. I just looked down and it speaks to the sort of companies I search for:

A thing of beauty is a joy forever;
Its loveliness increases; it will never
Pass into nothingness.

Go Rule Makers! :)

Thanks for a great note,

Tom Gardner
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I wonder how important it was to know precisely when to buy The Gap during this 22-year period that it has compounded 26% annual growth. I wonder when a potential investor in Merck over the past forty years was best off trying to pick entry points (risking missing out altogether) rather than just buying into what has been 18% annual growth over those last four decades.

Tom!

It is tremendously important to know precisely when to buy a company. Simply because you buy a stock that is enjoying a certain compounded rate of return on its stock price does NOT mean that you will necessarily enjoy that same rate of return. The price you pay determines your rate of return.

If, by buying Cisco, I am paying 30% more than the company is worth today, it's likely I won't remember that if Cisco then compounds 20% annual growth over the next twenty years. I will have made 27x my money over that period. If I can do that without commission costs, with long delayed tax costs, and without adding any new money, I would hope that I would find this sufficient to support a rather high quality of life.

If you pay more for the company than it is "worth" today, then you are NOT going to realize the returns you expect. "Worth" is a very subjective term. Some people require only to modestly outperform the long-bond. Others require 15% or more return on their investments. If you are paying 30% more than what YOU believe the company to be "worth", then you are necessarily paying too much. "Intrinsic value" is not a static, universal number -- it is determined by the requirements of each investor of capital.

If Cisco is to appreciate at 20% a year, compounded for many years in the future, and you expect 20% return on your money, you WILL NOT realize that rate of return if you pay 30% MORE for the company today than it is "worth". If you buy Cisco at 100 and it returns 20% per annum for the next ten years, you WILL NOT enjoy the same rate of return if you pay, say 110 per share for the same company tomorrow. That's just math. Simply buying shares of a great company is not enough -- you have to buy that company at an advantageous level.

The price you pay determines your rate of return.

Looking forward to your reply . . .

Paco

Paco Ahlgren, President/CEO
Ahlgren Capital Management, Incorporated
The Popperian Group, L.P.
752 Island Drive Memphis, TN 38103 901.522.9470

Message Boards: http://forums.delphi.com/m/main.asp?sigdir=ahlgren

paco_ahlgren@yahoo.com ahlgren@midsouth.rr.com

Instant Messenger I.D.: pecunio


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Paco,

I think you may have miscalculated the numbers there. If I buy Cisco and suffer a 30% loss at the outset, followed by 20% annual growth over the next twenty years, I will indeed have 27x my initial investment at the end.

True, if I'd waited until the 30% drop to purchase the stock, and picked it perfectly there, I'd have 38x my initial investment after 20 years of 20% annual growth.

The problem is that I have yet to see anyone who can consistently pick the wiggles and waggles on a stock graph. I have, however, seen thousands of examples now of individuals who either did not buy a great business or sold their holding in a great business because they thought the "stock was overvalued at the time." To my thinking, that's the far greater risk.

I'd rather take my position in a great business then add on dips in the years ahead, if the company is continuing to chug forward into greater success. Waiting on the stock of a great business to fall before I enter, though, just ain't how I play the game. I hope the Rule Maker Portfolio will help to illustrate the benefits of this approach. It certainly isn't the only way to go, though!

Fool on,

Tom
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Tom,

Let's look at this carefully.

Regardless of the price you pay for a stock, if that stock appreciates in value from your purchase price at a compounded rate of 20% per year, then you have achieved your goal (presuming a required return of 20% or less per year). You are correct in that observation.

Now if I could see into the future and have absolute certainty that a company were going to perform as such, then I could do very well indeed.

However, we don't have absolute knowledge. The best I can do is analyze companies using historical (financial) performance data.

Let's use Coke as an example. Coke is a wonderful company whose historical performance has been fabulous.

Using free cash flow as the numerator, historical Return on Total Capital has averaged 33% over the last decade. ROE has also average 33%. ROA has averaged 15% and Net Profit Margin has averaged 16%. Other multiples are equally impressive. These are great numbers, especially when you consider that I have foregone the traditional (and easily manipulated) EPS number in favor of free cash. There is no disputing the financial strength of Coke, and when you add brand-name and potential markets, you have a formula for outstanding growth.

However, at its current price, and considering its historical growth rates, I predict that Coke's stock price should appreciate no more than 2%-3% per year for the next five years. I need to be clear: I am NOT saying that Coke, as a company, can't grow at it's traditional rates, but I am saying that even if Coke DOES grow at those rates, the stock may not appreciate in tandem, simply because Coke's price has already gotten so far ahead of itself -- in terms of price appreciation.

According to my calculations, Coke is approximately 100% over-valued (I would start buying at around 31).

The only thing that would change this is growth, but I doubt that Coke is going to report numbers so astounding that it creates a "buy" for me at 62.5.

Let's say that Coke drops to 40 and nothing else changes. At that point, it would be about 30% overvalued (by my calculations). I still would not have reached my requirement of potential 15% or more per year growth in invested capital.

At that point, however, according to your reasoning (if I am reading it correctly), I would presumably do well to purchase Coke, even though its price would be overvalued (according to my subjective interpretation of "worth" or "value").

But at that price, its price growth will still only be about 10% per year, according to my calculations. Maybe Coke will pile on a compounded return of 20%. But, historically speaking, Coke should only return about 10% at $40 per share.

The big "if" in your analysis is the compounded rate of return. Sure, if you buy Cisco at $100 per share and it returns 20% a year, you WILL do great. But the price you pay DOES affect your rate of return. And IF Cisco is going to return 20% per year at 100, how much will it return at 75? Or 50?

And you have to ask yourself at what point Cisco STOPS delivering 20% per year in price. There is a point.

What you advocate may induce investors to believe it's "okay" to purchase something like Coke at 62.5. Maybe it is (although I don't believe that is true), but that's NOT how Buffett does it. Coke is a great company, and we all love it tremendously. But at some point, companies DO become overvalued. To wantonly buy them at any price because of brand-recognition and historical consistency ALONE is not wise.

One of the most consistent companies, with a TREMENDOUSLY recognizable brand is Wrigley. But Wrigley is almost certain not to show up on the BRK list of holdings -- it never gets low enough in price to offer the kind of returns expected by management. Buffett has been clear about that. The reason is that Wrigley is SO consistent that investors value it like a bond.


Buffett and Munger are explicit:

"[A fat pitch] is what we look for. And that's what I would try to teach students to do." -- Buffett

"How much weight should one give quality vs. price? All I can say is we like to pay a comfortable price." -- Buffett

They have, on numerous occasions, stated that their waiting time is "almost indefinite".

Thanks for your response. I look forward to reading more of your thoughts.

Paco
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Paco,

I understand this line of reasoning, and I accept it as an alternative. As an investor with a fairly contrary perspective, all I can suggest is that we watch the numbers over the next decade. When I modeled the earlier versions of this portfolio, all the measurements called the stocks overvalued. Those same measurements would never have justified buying Dell in 1990 and holding it through to today, yet it's been the best performing stock in the U.S. this decade.

We'll just have to see how the numbers play out over time. Of course, in the Rule Maker Portfolio, we'll be accounting for all costs associated with running the portfolio, including discount-brokerage commissions and taxes. As always, we believe that all portfolios should reflect the total cost of managing them as well as a clear reflection of the net rate of return of the portfolio versus the S&P 500 and/or Wilshire 5000.

It will be interesting to see if The Maker Portfolio beats the market over the next decade. I believe we will and that this approach will far outpace the often expensive advisory services offered up there in Manhattan! Net rate of return vs. the market's average on a full-service brokerage statement. . that would be novel!

Time and the numbers will have to answer this interesting exchange. Thanks, Fool.

Tom
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Thanks for the response, Tom.

I know you are busy as hell. I hope the tour is going well.

Paco
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The fact that Satan has a hold of Kathy Lee Gifford is discouraging. I'll never forget what Claude "Sheriff Lobo" Akins said to me one night at Bible study. He said "Kathy Lee can really work it". But he was full of fire-water and had eaten too many sliders and nails from White Castle. He also "claimed" to have invented "Alf" that night.

The Bible has always been with me, but some that come late to Jesus have the need for such things as mini-burgers laden with fat and side orders of salty snacks.

HT.
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None of that matters. I was with her and she was smoking.

Hey, TowelBiter: If it hadn't been for BJ and the Bear, Lobo would have been camel dung. Put that in your Bible and read it.

Paco
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